An annuity is a contract between an annuitant and an insurance company, in which the annuitant pays the insurer a specified amount of money and receives, in return, regular payments for a stated period of time, which period of time may be the life of the annuitant. The specified payment is made at the time that annuity contract is entered into, and the insurance company invests the money paid. At a future time, the annuitant receives the benefit of the money invested in a stream of payments which corresponds to the growth of the investment.
There are two basic types of annuities: fixed and variable. In fixed annuities, the annuity stream is a fixed amount in accordance with a payment schedule. In a variable annuity, premiums may be invested in a variety of financial instruments, ranging from individual stocks and mutual funds to real estate and certificates of deposit. Thus, the annuitant's return will fluctuate in a variable annuity, depending upon the market and the success of the portfolio.
Because of the hybrid nature of variable annuities, which often combine some insurance-like assumptions of risk by the insurer, with securities-like assumption of risk on the part of the contract owner, the United States Supreme Court ruled in SEC v. Variable Annuity Life Ins. Co., 359 U.S. 65 (1959), SEC v. United Benefit Life Insurance Co., 387 U.S. 202 (1967) that variable annuities are both insurance contracts and securities, subject to both state insurance regulation and federal securities regulation. A mutual fund is an open-ended fund operated by an investment company, which raises money from shareholders and invests in a group of assets, in accordance with a stated set of objectives. Benefits to the shareholder include diversification and professional money management. Shares are issued and redeemed on demand, based on the net asset value, which is determined at the end of each trading period or session. Mutual funds are federally regulated securities, with markets risk entirely assumed by the investor.
Hybrids of insurance contracts and mutual funds have been developed. They are sold in a two-step process in which the end consumer purchased a share of an underlying mutual fund (federal security) and simultaneously, but as a separate transaction, becomes a participant in a group insurance policy. The participation in the mutual fund by purchase of shares allows the investor to fully participate in the market movement of the underlying fund. The group insurance contract typically states that the policyholder will receive a benefit only if, at the time of death, the value of the mutual fund share is less than the original purchase price. The hybrid process is both cumbersome for the investor and expensive to administer for the distributor, as it requires the simultaneous sale of two contracts regulated by different agencies (federal securities and state insurance). This mandates an added level of expense for the issuer, a layer of regulation for the distributor and transactional complexity for the consumer.